NASDAQ's Proposed Disaster
The Morning Call looks at the death of American business. Again
As many of you know, President Reagan’s biographer Lou Cannon tells a story about the late president that is one of our favorites:
My discovery came early in Reagan's California governorship, when his limousine was driven through hostile student demonstrators, one of whom thrust his face against the car and shouted, "We are the future." Reagan borrowed a piece of paper and wrote a note that he held up to the window. "I'll sell my bonds," it said.
Before we continue, we want to remind you of something: We are NOT investment advisors. The information contained herein is for informational purposes only and should NOT be construed as legal, investment, financial, or other advice.
Now, with that said, if you were to ask what our long-term investment strategy is, we’d tell you that we think Reagan was, as always, a man of vision. Sell our bonds. And everything else!
It would probably not shock you at all if we told you that, over the long term, we intend to be heavily invested in guns and ammo. Not gun and ammo stocks, mind you. But actual guns and actual ammo. Because in the not-so-distant future, that might be all that matters. Certainly, we don’t think we want to be invested in American corporations, long-term, given that the powers that be in this country are bound and determined to ensure that those corporations are uncompetitive, financially unsound, and dedicated to principles that have nothing whatsoever to do with performance or profits.
As you may recall, two days ago, we noted that the next iteration of ESG investing will judge corporations on a host of variables intended to promote social or political goals, NOT to promote sound business practices or anything even vaguely resembling solid investment value. Unfortunately, whacky, out-of-the-mainstream, quasi-religious zealot professors at Harvard Business School are not the only risks to the American corporate future. Indeed, they probably aren’t even in the Top 10 such threats.
Consider, for example, the following, which is news you may have heard but may not have placed in this context. Just over a week ago, the New York Times’ “Dealbook” newsletter reported the story thusly:
Nasdaq will ask the S.E.C. this morning for permission to adopt a new requirement for the 3,249 companies listed on its main U.S. stock exchange: have at least one woman and one “diverse” director and report data on board diversity — or face consequences.
Nasdaq will require boards to have at least one woman and one director who self-identifies as an underrepresented minority or L.G.B.T.Q. (Those categories are not, of course, mutually exclusive.) To give companies time to comply, they will need to publicly disclose their board diversity data within a year of S.E.C. approval, and have at least one woman or diverse director within two years. Bigger companies will be expected to have one of each type of director within four years.
Companies that don’t disclose diversity information face potential delisting, while those that report their data but don’t meet the standards will have to publicly explain why. Over the past six months, Nasdaq found that more than 75 percent of its listed companies did not meet its proposed diversity requirements.
Nasdaq lobbied the S.E.C. to make diversity disclosure a rule for all companies. “The ideal outcome would be for the S.E.C. to take a role here,” Adena Friedman, Nasdaq’s C.E.O., told DealBook. “They could actually apply it to public and private companies because they oversee the private equity industry as well.”
It would be the first time a major stock exchange demanded more disclosure than the law requires, which Ms. Friedman described as “an unusual step.” It raises questions about whether exchanges could use their listing rules to force action on other hot-button issues, like climate change.
Now, for the record, we think diversity – on boards, in management, among employees – is great. We think it’s a positive development and one that should, generally speaking, be supported. At the same time, we need to be clear about this: corporate diversity is a social and/or political undertaking. It is NOT a financially relevant factor. Those who favor politicizing the capital markets insist otherwise. But they’re wrong.
In its filing with the SEC, for example, NASDAQ claims the following:
Nasdaq reviewed dozens of empirical studies and found that an extensive body of academic research demonstrates that diverse boards are positively associated with improved corporate governance and financial performance. For example… studies have found that companies with gender-diverse boards or audit committees are associated with: more transparent public disclosures and less information asymmetry; better reporting discipline by management; a lower likelihood of manipulated earnings through earnings management; an increased likelihood of voluntarily disclosing forwardlooking information; a lower likelihood of receiving audit qualifications due to errors, non-compliance or omission of information; and a lower likelihood of securities fraud. In addition, studies found that having at least one woman on the board is associated with a lower likelihood of material weaknesses in internal control over financial reporting and a lower likelihood of material financial restatements. Studies also identified positive relationships between board diversity and commonly used financial metrics, including higher returns on invested capital, returns on equity, earnings per share, earnings before interest and taxation margin, asset valuation multiples and credit ratings.
Not to be pedantic, but you will notice that NASDAQ’s word-choice here is telling. The phrase that appears time and again is “associated with,” which, of course, is code for “we can’t prove a thing.” An “association” in the social sciences, is utterly irrelevant. We don’t know how robust that association is or the variables that define it or the variables that were controlled to demonstrate it. We don’t know anything other than that there is an association, just as there’s an association between eating bacon and being happy. It means NOTHING.
What we do know, however, is that NONE of the studies NASDAQ cites demonstrate causation, which is to say that none of them demonstrates that board diversity causes better corporate behavior. If they did, NASDAQ would have mentioned it. But it didn’t.
We haven’t looked at NASDAQ’s studies yet, but we have looked at a great many such studies over the last year. And what they show, essentially, is that companies that are conscientious about board diversity are conscientious about other matters as well. Socking, right? Forcing board diversity on companies that are not conscientious to begin with will not make them more conscientious. The ESG folks likely have the causation precisely backward when it comes to diversity.
Additionally, even the hypothetical benefits of diversity are diminished considerably when diversity is defined narrowly by sex or “underrepresented status.” “True” diversity, which would include diversity of viewpoints, ideologies, religious beliefs and practice, etc., fits the theory better than mere superficial diversity. Indeed, in 2009, the Securities Exchange Act of 1934 was amended to require listed companies to disclose and describe their diversity policies for the nomination of directors in their annual proxy statements. And in its final rule on the implementation of the diversity question, the SEC specifically and intentionally did not define what diversity should mean, believing that such decisions were best left up to the listed companies. The SEC wrote that it had voted to:
require disclosure of whether, and if so how, a nominating committee considers diversity in identifying nominees for director. . . .We recognize that companies may define diversity in various ways, reflecting different perspectives. For instance, some companies may conceptualize diversity expansively to include differences of viewpoint, professional experience, education, skill and other individual qualities and attributes that contribute to board heterogeneity, while others may focus on diversity concepts such as race, gender and national origin. We believe that for purposes of this disclosure requirement, companies should be allowed to define diversity in ways that they consider appropriate.
The SEC did this purposefully to allow corporations to create diversity policies that they could justify as having financial relevance to their unique performance goals and requirements. The SEC understood – and acknowledged – that the demand for uniform diversity requirements based on superficial categories would be legally and constitutionally questionable as well as detrimental to the sacrosanct notion that financial accounting and financial performance are the measures by which corporate health should be judged by their regulators. To vary from that objective measure would be to throw open the doors of corporate disclosure to any social, political, or even random whim.
The NASDAQ filing continues:
Nasdaq believes there are additional compelling reasons to support the diversification of company boards beyond a link to improved corporate governance and financial performance:
Investors are calling in greater numbers for diversification of boardrooms. Vanguard, State Street Advisors, BlackRock, and the NYC Comptroller’s Office include board diversity expectations in their engagement and proxy voting guidelines.
You’ll forgive us, but we’re unlikely to be convinced of the benefit of a proposal by an appeal to the wants and needs of the “Big Three” asset management companies, which together hold an average of 22+% of EVERY company on the S&P 500; which have no active financial interest in management or director competence; which have all recently decided tacitly to collude on ESG matters; which don’t have the ability simply to divest from companies; and which hold MASSIVE voting power that is divorced from their own direct financial interests. In fact, mentioning that “Vanguard, State Street Advisors, BlackRock” are in favor of something is more than enough to convince us that we’re against it.
Everything about NASDAQ’s proposal is nuts. But it’s not nuts in a quirky, roll-your-eyes-and-move-on kinda way. It’s nuts in that it will, if approved, set a precedent signaling that any social or political value may be imposed on corporations at the whim of the exchanges on which they’re listed. The proposals that will, inevitably, follow in this one’s wake will, over time, corrupt and corrode the effectiveness and value of American business. There is a cost to every mandate imposed on corporations. Sometimes, of course, these mandates are effective and their costs prove less significant than the value they return. But those are all FINANCIAL mandates. Moving beyond the financial to the social and the political will impose costs that simply cannot be recouped except through engagement with social and political players, creating an environment rife with corruption, graft, and rent-controlling behavior. And all of these will lead, in time, to uncompetitive and unprofitable businesses.
So…sell your bonds, we guess. And everything else.